Risk Model Validation (3rd edition)
First published:
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Regulation
Regulation
Introduction
Basics of quantitative risk models
Usage of statistics in quantitative risk models
How can a risk model fail?
The concepts of model risk and validation
Model risk frameworks
Validation tools
Regulation
Stylised facts and classical approaches
Benchmarking with machine learning
Extending the risk horizon
Modelling and simulation
Data
Model results
Impact of machine learning, outlook and conclusions
References
This chapter will provide an overview of the regulatory requirements regarding QRMs, their validation and their application to computation of capital requirements. It will concentrate on the generic recommendations proposed by the Bank for International Settlements (BIS), that is, on the Basel Accords and accompanying documents. Other requirements, such as national regulation and supervision, may of course deviate from these guidelines. The chapter will discuss the three Basel pillars and risk models under Pillar 1 and Pillar 2 by risk type, as well as stress testing and validation from a regulatory perspective.
Legislations around the world are at many different stages of implementation and interpretation of the different Basel Accords as a basis for banking regulation and supervision. However, this chapter will assume an idealised country where Basel III is in full force, describing the landscape of risk models involved and key validation requirements.
A SHORT HISTORY OF THE BASEL ACCORDS
In 1974, the liquidation of the relatively small Herstatt Bank gave rise to serious concern about how adequate banks’ capital resources were in times of financial crises. The central
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